FDIC’s Hoenig Issues Muted Call for Reform

On Wednesday, FDIC Vice Chairman Thomas Hoenig, known as an outspoken critic of the risky practices of the “too big to fail” banks, addressed the 22nd Annual Hyman P. Minsky Conference sponsored by Bard College in New York in a speech on a new model for banking titled “A Turning Point: Defining the Financial Structure.”

Retired as president of the Federal Reserve Bank of Kansas City, Hoenig is recycled at the FDIC and in a position to continue to play an active role in the debate over the topic of his speech — the search for a more appropriate model for the banking industry. Hoenig has spoken to earlier conferences, going back to when Minsky was alive and in the audience.

Hoenig spared the audience the paens to the virtues of community banking that usually mark his speeches. Instead, he concentrated on discussing the flaws in the current money center bank model that enables these banks to conduct risky, hedge fund-like activities under the umbrella of federal insured banks backed by the federal safety net.

He railed against the features of the current banking model that enables the too big to fail institutions to maintain massive derivatives portfolios on extremely thin capital with virtually no effective supervision by the federal banking regulators.

One of these features is the continued growth of the largest banks. Hoenig cited statistics showing that in 1997, the 10 largest banking companies held assets equivalent to 25 percent of the nation’s gross domestic product. By 2006, it was 58 percent, and it has since risen to more than 71 percent. Against all of the rhetoric about reforming financial regulation, Hoenig starkly stated, “The incentives toward risk taking remain essentially unchanged from pre-crisis times.” He predicted that the complexity of regulations would grow along with that of the industry until banks ultimately become equivalent to public utilities.

Hoenig proposed that greater attention be paid to the structure of the industry and the scope of the safety net so that only the payment system and long-term lending activity would be covered. He recalled that when the Glass-Steagall segregation between the commercial and investment banking segments was repealed by the enactment of the Gramm-Leach-Bliley Act of 1999, the scope of the federal safety net was extended to non-banking activities.

Now he calls for the momentum to shift back in the other direction through the implementation of the Volcker rule as a means of restricting the reach of the federal safety net to prevent banks from, in effect, running hedge funds funded, in part, by insured deposits and other short-term sources and backed by the federal government.

He also identified money market mutual funds as a source of systemic risk, because they invested in overnight bank debt and avoided marking their holdings to market. Hoenig called for these entities to be removed from the safety net and treated as uninsured deposits.

Hoenig lamented that instead of constricting the safety net, it has, in effect, been extended to the broker-dealer activities that are conducted by banking entities with less equity capital than mainstream banks. The market confers on these entities a funding advantage that enables them to continue to extend their scope and dominate any market they choose to enter. He stated that the target of his proposals is not bigness, but rather the combination of bigness and subsidy.

In presenting his argument, Hoenig departed from his prepared remarks to state flatly what some cynics have suspected — that the too big to fail banks operate with tangible capital of no more than 3.5 percent and under a supervisory system that lacks an effective plan for monitoring the true capital standing of the banks. He advocated that capital standards be strengthened significantly independent of risk weighting, which has proven ineffective, and he noted he would reform the supervision practices of the regulators so that they conduct systematic surveillance and analysis of the exposures posed by the assets banks hold.

Unfortunately, having brought the group of sophisticated scholars and experts in the field of financial regulation close to revival-meeting enthusiasm for his message, he backed off a bit.

When a questioner suggested that JPMorgan Chase CEO Jamie Dimon should be ousted, there was a smattering of applause, but Dimon invoked the “rule of law,” ironically, as a reason not to move against the symbol of banking as a government entitlement program. Leaving listeners to wonder, what about the rule of law?

On Wednesday, FDIC Vice Chairman Thomas Hoenig, known as an outspoken critic of the risky practices of the “too big to fail” banks, addressed the 22nd Annual Hyman P. Minsky Conference in a speech on a new model for banking titled “A Turning Point: Defining the Financial Structure.”